Market data clearly demonstrates that a spread exists between growth and value investing. However, it is critical for long-term investors to understand what that spread represents and how best to capitalize on it when it comes to their own investment portfolio.
As we have demonstrated on our website, value investing provides higher long-term returns on average than growth investing (read our article Value Consistently Trumps Growth for LT Investing). The value-growth spread further supports this position. Specifically, this spread represents a +26.6% value outperformance!
However, this outperformance isn’t free. Rather, it comes with a cost—risk (aka the value trap).
Thus, the question becomes: What investing approach provides the best risk-reward proposition?
In this article, we’ll explore:
The value-growth spread is real, and it is large.
The spread indicates that (1) less expensive stocks outperform more expensive ones and (2) stocks with a lower return-on-equity (ROE) outperform those with higher ROEs.
In fact, cheap stocks with low ROEs (i.e., traditional value stocks) outperform expensive stocks with high ROEs (i.e., traditional growth stocks) by 26.6% when you add ROE as a second factor.
Let’s look at an analysis of stocks from 1963 to 2012 and see how this value-growth spread works.
We’ll examine the performance of these stocks based on two-factor analysis: value and quality. This provides us with a basic matrix, consisting of four quadrants:
Specifically, we’ll use the price-to-earnings (PE) ratio as a representation of value and return-on-equity (ROE) as a representation of quality. We’ll also rotate the matrix to have PE form the X-axis. This provides us with a defined matrix:
When we crunch the data, we find that a value-growth spread emerges:
The spread indicates that traditional value stocks (low PE/low ROE) produce an average of +26.6% of annualized returns.
If we look at the return delta from the mean, we can more easily visualize where the greatest under and outperformance occur:
Furthermore, this clearly demonstrates that returns are inversely proportional to PE and ROE—meaning return increases as PE and ROE decrease.
In this case, we included high-PE stocks with negative earnings (i.e., unprofitable companies losing money). When we add a constraint that filters out those unprofitable companies, we find the following value-growth spread:
While the value-growth spread narrows, it is still significant at +22.5% in annualized returns.
When it comes to investing, return represents only half of the picture—risk is the other “hidden” half.
We can analyze risk by looking at the standard deviation of earnings growth-rates 2-years ahead. When we do this, we produce the following risk matrix:
If we look at the risk delta from the mean, we can more easily visualize where the greatest under and outperformance occur:
This demonstrates that risk decreases as PE drops and—even more significantly—increases as ROE decreases.
As we did with returns, we can add a constraint to filter-out unprofitable stocks. When we do, the data produces this result:
[Note: I’ll post the complete data for each of these four matrixes at the end of the article]
When we combine the data from returns and risk, it provides us with a clearer picture of the risk-reward story… which provides a value-growth matrix that looks like this:
Stocks in quadrant I represent growth stocks that are expensive and have a low ROE. These stocks can be characterized as high-risk, high-reward investments. In other words, you’ll either knock it out of the park or lose big.
Stocks in quadrant II represent growth stocks that are expensive but have higher ROEs. These stocks can be characterized as moderate-risk, low-reward investments.
Stocks in quadrant III represent value stocks (in a more traditional sense) that are cheap and have low ROEs. These stocks can be characterized as moderate-risk, high-reward investments.
Finally, stocks in quadrant IV represent value stocks that are cheap but have higher ROEs. These stocks can be characterized as low-risk, moderate-return investments.
The first takeaway is that growth drives the market… and it is risky!
Let’s look at the risk-reward setups for growth stocks and value stocks.
When you purchase an expensive growth stock (high PE), you are paying for growth up-front. You can pay for that growth in a stock with a low ROE or high ROE.
With a high ROE, your potential return is minimal. You’ve already paid for the growth. Any alpha from your investment will require even more growth to materialize on top of the high expected-growth you’ve already bought. On the flip side, if future grows turns out to be less than that high expected-growth, you lose—and that loss can be significant.
With a low ROE, your potential return is high. While you’ve already paid for a lot of future growth, there is still a lot of runway available should the company become more profitable. However, you are betting on that happening. If it doesn’t, you are likely to lose big as the price will decline far more than it would for a stock in the first group.
Another way to view these quadrant-I stocks is that the market has priced in strong future earnings. However, accounting obviously doesn’t recognize them due to the uncertainty principle. This leads to a high PE. Furthermore, these companies tend to be upstarts and, thus, are investing significantly in future growth (e.g., R&D, start-up costs, marketing, etc.)—costs that are expensed. This reduces their profitability (if they had any) and ROE even more.
For this group of stocks, it all comes down to whether that investment is successful. If it is, it will produce monster growth down the road and a big win for investors. However, if it fails, then the expected growth will evaporate and investors (who paid for it up-front) will be left holding the empty bag with a monster loss.
When you buy a cheap value stock (low PE), you are not paying for future growth. Rather, you are rewarded for it if it materializes. As with growth stocks, you can buy value stocks with low ROEs or high ROEs. Let’s look at each scenario.
With a low ROE, you are buying a traditional value stock. These are typically distressed companies on their way out. However, if they can turn things around (produce unexpected future earnings), the reward is high. If they can’t, your loss will be significant—though not as bad as it would be with a growth stock because of the much better margin of safety (MOS).
This is also known as the value trap! Cheap doesn’t equal good! Just because a stock is cheap doesn’t mean it’s a value. Unless that company can turn things around (not the norm), no value or return will exist for you. If you can identify stocks in this category that have a high potential to turn things around (and do so before the market does), then you have the potential for a huge payoff.
With a higher ROE, you are buying more of a growth stock—but at a value. This typically occurs due to either (a) a market overreaction to a short-term catalyst or (b) an entire sector or industry being beaten down (e.g., sector rotation)—including the quality companies within it. You are getting the likely growth of a higher ROE company, without having to pay for it up-front. When that growth materialized, you benefit with solid gains. Furthermore, your risk is limited because (a) you didn’t pay for that growth up-front (MOS) and (b) it would require a deterioration of profitability (declining ROE). If you have done your fundamental analysis on the company, you should have been able to identify an intact fundamental story.
The takeaway for the long-term investor is that value trumps growth investing over the long run!
With growth investing, you have a poor risk-reward proposition. With high ROE companies, you’re upside down—small upside reward and significant downside risk. With low ROE companies, it’s all or nothing! And more often than not, it will be nothing.
But what about Google and Amazon? Growth proponents love to tout the rare winners, while ignoring the massive number of total losers. In order to really have benefited from huge growth winners like these, you needed to identify them when they were in quadrant I! In other words, you would have needed to invest a large chunk of change when they were small and unprofitable. Unfortunately, when they were, they were just one of hundreds—if not thousands—of potential seeds. Most of those seeds failed to sprout!
The best approach—one backed by the empirical data—is value investing.
Unlike growth investing, with value investing, you put the risk-reward proposition in your favor over the long run. With low ROE companies, you have a huge upside and moderate downside risk. Furthermore, the better you are at fundamental analysis, the more you can limit that downside risk of a value trap. With high ROE companies, you have a moderate upside and small downside risk. And, the better you become at valuation, recognizing market overreactions, and identifying sector rotations, the more you can limit the downside.
To put it in layman’s terms:
That’s the value-growth spread!
It’s one thing to understand a theoretical implication… but it means nothing if we can’t apply it in the real world to produce actual results!
I would argue that there are three practical ways we can apply the value-growth spread to our own investing—ways that can help us capitalize on the potential outperformance it identifies.
The number one takeaway from the value-growth spread is that your overall (top-level) investment approach matters!
There is a spread—it’s real. Whether it’s a PE spread, ROE spread, or combination spread, the numbers don’t lie.
When you combine that knowledge with your investing time-horizon, it largely defines the range of possible outcomes for both your returns and your risk.
We need to carefully develop our investing plan (meaning very thoughtfully) and then stick with it.
I find that if folks put as much time, thought, and effort into their investing plan as they do into individual investment analysis, they would achieve far greater results over the long run!
You need to decide for yourself how you are going to capture a portion of that spread—that’s what your investing plan is for.
You can’t benefit from a statistical edge if you are bouncing all over the map with your investments. You have to be targeted, consistent, and allow the law of large numbers (frequency/occurrences) to work for you.
For the long-term investor (including dividend-growth investors), I would recommend a value-centric investing approach. The empirical data overwhelmingly demonstrates that value trumps growth.
When we combine the return and risk data presented above, we can create a “hitting zone”—much like you see in baseball. It is a highly practical tool for identifying which zones a given batter is hot and cold in. A pitcher can use it to determine where best to throw pitches (the cold zones) and a batter can use it to determine which pitches they should swing at (the hot zones).
As Warren Buffett aptly notes, there are no called strikes in investing. We don’t have to “swing” at anything. Unlike a batter in baseball, we have the luxury of waiting for the perfect pitch to swing at—one in our hot zone.
But… we need to know what those hot zones are. And that is where the value-growth spread data comes in. It can provide us with a practical hitting zone map for our investing.
For our site’s public passive-income portfolio (PIP), that map looks like this:
If you are a long-term dividend-growth investor, you want to stick to low-PE/high-ROE opportunities.
Why? Because you want the profitability to drive future growth (and dividend increases), but you want to pay as little up-front for that future growth as possible.
If you are more of a pure value investor, you want to focus on (or at least expand your hitting zone to include) stocks with low PEs but low- to mid-ROEs.
In our PIP, we are 90% focused on DGI. However, we will swing at some pure value plays (1) when they are highly favorable and (2) with smaller position sizes. When we do, we understand that our time-horizon is shorter than with our long-term positions (typically 1-3 years).
Remember, with pure value plays, we are simply looking for the stock price to return to fair value—and then we’re out. It’s not a buy-and-hold forever play. Also, as the value-growth spread data indicates, these are much riskier investments. They can produce large gains if a turnaround is successful… but they can also become value traps!
By sprinkling in some pure value plays when the opportunity (pitch) is right, we add some additional fuel to our portfolio. These gains are then reinvested into our long-term dividend-growth positions. It’s a layered approach—something we’ve highlighted in many of our articles.
The practical takeaway is that you need to identify your own investing zones—based on your personality, KSIs, financial goals, and risk profile/tolerance—that enable you to tap into the spread.
By utilizing a simple PE/ROE matrix and identifying hot zones, we can effectively and efficiently capitalize on the value-growth spread.
However, and it’s a BIG however, it is critical to understand that this is only a high-level filter.
While it can provide us with tremendous practical benefits and advantages by identifying “pitches” that are out of our sweet spots or in our hot zones, that’s all it does!
It is not a swing TRIGGER!
Once we identify a pitch in our swing zone, we then must conduct a thorough fundamental analysis to determine whether we want to actually swing or not.
Research is time consuming and there are thousands of pitches that we could consider. The value-growth spread provides us with a simple, quick, and effective PE/ROE filter to reduce the number of pitches we could potentially swing at to a manageable level. Thus, it improves our efficiency and, by keeping us in the right zones, improves our results (i.e., we benefit from the spread).
But again, it is simply a tool—a filter to be more specific. It narrows our focus to those pitches with the greatest potential to capture a portion of the spread… but it does not and cannot tell us if we should actually swing at any of them. That requires fundamental research. We don’t buy just because something is (a) cheap and/or (b) profitable.
The value-growth spread is real. The value-growth spread is significant… +26.6% value outperformance overall and +22.5% value outperformance for profitable companies.
When you combine value (PE) with profitability (ROE) into a two-factor analysis, the empirical data over a period of fifty years unambiguously demonstrates that we can (with a high-degree of statistical confidence) identify the risk-reward proposition for a given segment of stocks—specifically, the four quadrants (High-PE/High-ROE, High-PE/Low-ROE, Low-PE/High-ROE, and Low-PE/Low-ROE).
This knowledge allows us to develop an overall investing approach and then filter out stocks that are not a good fit for our strategy.
In general, dividend-growth investors will want to focus on quadrant IV—stocks with low PEs and high ROEs (providing moderate returns with lower risk).
Pure value investors will want to focus on quadrant III—stocks with low PEs and low ROEs (providing high returns with moderate risk).
The biggest takeaway is that growth is risky—it can evaporate for a myriad of reasons. Thus, you want to avoid pre-paying for future (potential/unrealized) growth. Doing so stacks the deck against you.
To the contrary, employing a growth-investing approach stacks the deck in your favor over the long run—hence the massive spread.
If you’re interested in dividend-growth investing and/or looking for valuable insights into value investing, then you’re in the right place!
At Wicked Capital, we focus exclusively on helping others become as successful as possible with dividend-growth investing and we hope you’ll continue to return to our site to learn, grow, sharpen your skills, and find effective and positive ideas and motivation!
Soak it all in, take and use what you want, modify it to fit your unique situation, and keep building that DGI portfolio with a solid process and winning long-term investing mindset!
Stephan Penman, George O. May Professor of Financial Accounting at Columbia Business School, Presentation as part of the Program for Financial Studies’ No Free Lunch Seminar Series, 5/10/17.
Always remember, investing involves substantial risk of loss and is not suitable for everyone. The valuation of investments may fluctuate, and, as a result, you may lose substantial amounts of money. No one should make any investment decision without first consulting his or her own financial adviser and conducting his or her own research and due diligence.
You should not treat any opinion expressed on the Wicked Capital website as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of opinion for entertainment purposes.
The opinions are based upon information we consider reliable, but neither Wicked Capital nor its affiliates, partners and/or subsidiaries warrant its completeness or accuracy, and it should not be relied upon as such.
Past performance is not indicative of future results. Wicked Capital does not guarantee any specific outcome or profit. You should be aware of the real risk of loss in following any strategy or investment discussed on this website.
As noted above, strategies or investments discussed may fluctuate in price or value. Investors may get back less than invested.
Investments or strategies mentioned on this website may not be suitable for you. The material presented does not take into account your particular investment objectives, risk tolerance, financial situation, or needs and is not intended as recommendations appropriate for you. You must always make an independent decision regarding investments or strategies mentioned on this website. Before acting on information provided on this website, you should consider whether it is suitable for your particular circumstances and strongly consider seeking advice from your own licensed financial or investment adviser.